Demand for Indian paper continues to be strong among foreign investors, going by the oversubscription of most IPOs and qualified institutional placements. But the Securities and Exchange Board of India’s (Sebi’s) curbs on participatory note (PN) issuances have hit foreign institutional investor (FII) activity in the secondary markets significantly.

Since 26 October, the day the curbs were effective, FIIs have been net sellers of equities worth Rs4,521 crore, according to data published by Sebi. But this is adjusted for share purchases by FIIs in QIP and IPO issuances. They bought shares worth at least Rs1,200 crore in IPOs since 26 October, which takes their net sales in the secondary markets to Rs5,721 crore. It’s not clear how much FIIs invested in QIPs, but a majority of these institutional placements are normally made to foreign investors. Since the PN curbs were introduced, QIPs worth Rs7,270 crore have been issued, Bloomberg data shows. Assuming that 60% of QIP issues were to foreign investors, the net sales figure in the secondary markets would be higher than Rs10,000 crore ($2.5 billion).

That’s not all. In the more liquid derivatives segment, FIIs have taken net short positions worth Rs21,111 crore since the PN curbs were put in place. The curbs in the derivatives segment were more stringent, with FIIs expected to pare existing positions in 18 months’ time. Not all of these short positions would be square-off transactions—they could well be fresh short positions by registered FIIs.

It’s interesting to note that despite net sales worth over Rs31,000 crore ($7.8 billion) by FIIs, the Sensex has remained steady at the 19,200 levels since 26 October. Domestic institutions have had a large role to play in counterbalancing FII sales. According to data published by the Bombay Stock Exchange (BSE), domestic institutions including mutual funds, insurance companies and banks have bought equities worth Rs14,080 crore since 26 October in the spot market.

Another large source of inflows has been retail investors. This is obvious from the outperformance of mid-cap and small-cap indices during the period. BSE’s mid-cap index rose 17%, while its small-cap counterpart jumped 27% at a time when the Sensex has remained flat.

Equity valuations

A look at the accompanying chart shows why the PE multiple for Indian stocks has expanded so much in the last few years. In addition to earnings growth, there has been all-round increase in efficiency. For instance, the return on capital employed for the BSE-500 companies (not taking banks and oil companies into consideration) from 18.61 in FY04 to 19.84 in FY07. Note that this has happened in spite of dire predictions that the high ROCE (return on capital employed) of Indian companies are not sustainable. Also, in spite of higher interest rates, the interest cover of companies in the BSE-500 has also shown a steady improvement.

As a matter of fact, interest cover has improved from 4.50 times in FY04 to 8.78 times in FY07.

What’s more, the trend for the BSE-500 companies is replicated in the larger universe of all companies (leaving out banks and oil companies) in the Capitaline database.

The crux of the matter, of course, is whether FY08 will see a reversal of this trend. A Reuters survey of earnings forecasts finds that EPS (earnings per share) estimate for the BSE-100 universe is Rs477.87 for FY08, compared with Rs410.69 in FY07. That’s an earnings growth of 16.4%, much lower than the 36.4% rise in EPS for the BSE-100 in FY07. It’s also well below the price-earnings (PE) multiple of 26.9 for the index.

The PE to growth ratio is at 1.64, an indication that stocks are overvalued. Market analysts are quick to point out that a sizeable chunk of corporate India’s valuation is for assets that currently don’t add to their earnings.

A classic case is that of Reliance Industries Ltd’s gas discoveries, which have driven the rise in the firm’s valuations although they haven’t added anything to the company’s earnings substantially. Adjusted for this, the PE to growth ratio is more reasonable.

Also, Reuters estimates that earnings growth for the BSE-100 will be higher, at 18.1% in FY09. Even with that higher earnings growth number, it will be difficult to justify current valuations. But there are wide variations in earnings growth estimates, with Reuters forecasting EPS growth of 59% in FY08 for financials in FY08, 58% for telecom companies and 32% for industrials, contrasted with 3% EPS growth for basic materials companies, -3% for health care and 10% for cyclical consumer goods and services.

The silver lining is that the Reuters estimates have had to be revised upwards. Six months ago, for instance, the estimate for EPS growth for the BSE-100 companies in FY08 was just 11.67% and for FY09 12.07%, which have since seen an upward revision to 16.4% and 18.1% respectively, doubtless on account of robust reported quarterly earnings.

Perhaps the market is betting on more upward revisions.

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